Two B’s are Better than One…and Three

Posted on September 20, 2018

Often times referred to as “high quality” or “upper tier” high yield, BB-rated bonds are a frequently overlooked asset class that offers investors attractive absolute and risk-adjusted returns. Sitting at the top of the high yield bond market rating scale, the BB market is a robust market in and of itself and now encompasses $546bn in market value across 310 issuers and 820 distinct issues.[1] BBs currently represent approximately 43% of the $1.27trn high yield market.[1] For comparison purposes, ten years ago, as the domestic economy was emerging from the Global Financial Crisis, the BB market was just $214bn in market value and 33% of the overall high yield market.

As shown in the chart and table below, BB-rated bonds have a long-term track record of superior absolute and risk-adjusted returns compared to BBB and single-B rated notes.

There are several key attributes that lead to the higher absolute return and Sharpe Ratio for BB bonds:

Default realization: The average annual credit loss[2] rate since 2000 for BB-rated bonds is roughly one fourth that of single-B rated bonds. As the table below shows, the actual credit loss rate during that time period is 0.40% for BB bonds and 1.61% for single-B issues. BBB bonds realized a 0.16% credit loss rate over the same period. The average spread pick-up, or advantage, BBs have enjoyed over BBBs since 2000 is 180bps – more than enough compensation, in our opinion, for relatively little incremental credit loss. Additionally, BBs have historically delivered more than two-thirds the spread of single-Bs with only 25% of the credit loss risk.

Coupon and carry: BBs have proven to be a lower credit loss, higher carry asset class throughout periods of declining and rising interest rates. With an average coupon of 7.13% vs 6.11% since 2000[3] , BBs have more than a 100bps cushion over BBB’s. Coupons for Bs have averaged 7.99% over the same time period, which is impressive, but have not compensated investors for higher credit loses relative to BBs. Admittedly, coupons have compressed across the entire fixed income landscape during the recent low-interest environment, but the relationship outlined above remains true despite the absolute coupon value.

Moderate duration: Compared to other fixed income assets, high yield is generally a shorter duration asset class. Average modified duration for BBBs, BBs, and Bs since 2000 is 6.73yrs, 4.78yrs and 4.21yrs, respectively[1] . With duration nearly two years shorter, BBs are less rate sensitive and tend to outperform BBBs in rising rate environments. At a duration of 4.21yrs, Bs will likely outperform in rising rate environments as well, but credit losses over a market cycle tend to negate any outperformance.

Turning to fundamentals, credit quality amongst BB-rated issuers is quite good. Net leverage continues to decline, and is below its long-term average of 4.2x[1] . Net leverage and coverage for BBB- and single-B rated issues has also improved, but not to the extent of the improvement in BBs metrics. Revenue and EBITDA growth for the high yield market overall was +8.1% and +12.9% in the first quarter, according to JPMorgan, and the second quarter is tracking to be even better. Additionally, as discussed in a previous blog post, High Quality High Yield Set to Benefit from Tax Reform the tax reform act passed in late 2017 should help to improve the after-tax cash flows of most corporate issuers, especially BBs. In time, this will enhance the credit quality of the market as companies have less incentive to incur more leverage as the after-tax cost of debt increases.

Credit investors, in general, have enjoyed the recent span of above trend economic growth, low interest rates and benign defaults. It is difficult for investors to predict when the current expansion will turn or how quickly interest rates will rise, but BB-rated bonds have provided superior risk-adjusted returns across market cycles. Historically nominal credit losses should continue to be tempered by improving leverage metrics and the effects of accommodative tax policy will become increasingly evident in the quarters to come. These factors, combined with attractive carry and modest duration, put BBs in the sweet spot of the credit spectrum.

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